NEW YORK, April 5 (Reuters Breakingviews) – In baseball, when fans turn their caps backwards or inside out it’s a kind of prayer that their team can turn its fortunes around. The commercial real estate industry has a different kind of backward cap – one that’s also a sign of a losing streak.
Anxiety over U.S. commercial property has been heightened by the collapse of two banks, one of which – Signature Bank – was an active real estate lender. Building-related debt has been the cause of crises before. Lehman Brothers’ purchase of apartment company Archstone in 2007 was one reason for its eventual bankruptcy.
The problem this time is a key real estate metric called the “cap rate.” Nothing to do with headgear, this rate reflects the yield on a property, comparable with the yield on a bond. The cap rate comes from dividing a property’s net operating income in any given year – money from rent minus associated costs – by the asset’s value. Ideally, and almost always, it’s higher than the rate at which the owner can raise debt to fund their purchase.
For more than 10 years, that gap remained positive even though cap rates were falling in virtually all real estate subsectors, from shopping malls to apartments. That was mostly a consequence of low interest rates. And the spread made it possible for asset prices to keep rising even though rents, a major driver of net operating income, weren’t going up much. As recently as 2020, the spread was as high as three percentage points.
That narrowed suddenly when the U.S. Federal Reserve turned course and started putting interest rates up with unprecedented speed. For the first time since just before the financial crisis, the baseline cost of debt – the 10-year Treasury – is higher than the yield the owner will get on a building – a situation known in the industry as “negative leverage.” When a new investor risks getting a yield that’s less than the cost of debt, the obvious thing is for them to demand a steep price cut.
Ask a large-scale real estate owner – or several – about this and they are characteristically optimistic. They’ll say the rents on the buildings they own are about to rise, too. Have no fear: Their cap rate growth will outpace the increase in rates, and this inversion will soon revert.
But that’s only true for some. One factor is the type of property: There’s still a shortage of good rental homes, retail rents are rising, and warehouse vacancy rates are relatively low. But office valuations are struggling. The other variable is location. Real estate consultancy Trepp found that in San Francisco, more than 60% of office property loans were close to or in default; so were almost 40% in Washington, D.C. Last month, the Real Deal trade publication reported that Brookfield Properties, a majority owner in New York skyscraper One Liberty Plaza, was trying to buy back the other 49% for a third less than what private equity firm Blackstone (BX.N) paid for the stake six years ago.
One further problem is that changing work habits have spoiled the math of rental increases. Vacancies in the office sector are at 18% on average, up from 12% in 2019, according to the National Association of Realtors. If tenants don’t renew, it puts pressure on net operating income. The spread between the cap rate and cost of debt makes a big difference then, because leverage magnifies the effect of falling income on the equity investor’s cash flows.
Take a fictitious property investor, Brookrock Global. Say it bought a property three years ago with $10 million of net operating income and a yield of 5%. That deal would imply the building is worth $200 million. But if some tenants don’t renew, and others renegotiate, net operating income might fall to $7 million. If Brookrock tries to sell, a new buyer might look at interest rates close to 5% and demand a cap rate of 7%. In that scenario, the value of Brookrock’s building is cut in half.
This fictional example is about to become reality as a wave of refinancings approach. Some $600 billion of commercial real-estate debt is coming due this year and next, according to Cushman & Wakefield, the vast majority of it issued when rates were lower. Lenders will look at new, lower valuations and reassess the amount they’re prepared to lend. If Brookrock borrowed 60% of the value of its building in 2018, and a bank will only lend 60% of its valuation today, the owners must find $60 million from somewhere to pay back its original loan.
When Lehman Brothers went bankrupt, the narrowed spread between cap rates and interest costs didn’t last for long. The Fed started to cut rates to save the economy. With inflation running high, that looks unlikely today. And if rates don’t move, and nor does operating income, that leaves valuations to take a big hit.
Baseball fans call their backwards-and-inside-out headwear a “rally cap.” And usually it’s seen when a comeback looks nearly impossible short of a real stroke of luck. Real estate investors will need even more than that.
(The author is a Reuters Breakingviews columnist. The opinions expressed are her own.)
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Editing by John Foley and Amanda Gomez
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